Many companies that offer unique or custom products figure out what to charge by adding up their costs and tacking a markup on top of that. That’s called cost-plus pricing. Without being careful, however, you may find that cost-plus pricing can actually benefit your customers more than you.
I worked with a company that had a system they used to quote prices for complex industrial jobs. The system would add up all the direct material, labor and overhead costs and tack on a standard markup that would ultimately generate a price to give to the customer.
However, management thought that there was something wrong with the system. It kept generating estimates that were far lower than the previous year. After digging into the details, we found that they had changed the manufacturing process, resulting in significant cost savings in labor. The person who was in charge of inputting the costs into the sales tool followed standard procedures and put in the new, lower cost in the system.
No one caught the change for 6 months. The system used the cost-plus model, so with lower costs, the final price was lower, ultimately passing all the cost savings on to customers. For this company it meant hundreds of thousands of dollars of lost revenue—and profit–until the system was fixed.
There are a few downsides of cost-plus pricing.
Downside #1: Unintentionally passing along cost savings to customers. As in the example above, it is easy to see that without monitoring, you can pass on more to your customers than you think. Our experience has also been that most of the time, cost savings are evolutionary– whether it is a minor change to a manufacturing process or simply hiring a new employee at a lower rate than existing employees. Efficiencies often come in small doses.
Businesses impacted the most are ones that deliver custom products or solutions to clients. If they build their estimates from scratch, or use previous jobs as a baseline and don’t adjust their markup for these cost savings, they may find that their customers are benefiting more than they are. Granted, there are times when passing along cost savings is beneficial, but at least it make it deliberate.
Downside #2: Leaving money on the table. While cost-plus pricing ensures that you cover your costs (and then some), it doesn’t take into consideration what your customers are actually willing to pay for it. A few targeted surveys may tell you if you are under-pricing yourself.
Downside #3: Inflexibility responding to competition. It’s rare that companies price their products without knowing what the competition is up to. However in a pricing war, there is only so much margin that you can lose to be competitive. Over time, cost-plus pricing doesn’t incent the business to become more efficient—as its costs go up the price does too, until the company starts pricing itself out of the market. By then it may be too late to lower costs to keep its position.
Cost-plus pricing has its upsides because it is an easy way price goods and services, however if you use this method, be careful to monitor it. Otherwise, the “plus” sign may wind up in your customers’ pockets and not yours.